Debt-to-Income Ratio - It's Just as Important as Your Credit Score When You're Shopping for a New Home

Your debt-to-income ratio (DTI) is a simple way of calculating
how much of your monthly income goes toward debt payments.
Lenders use the DTI to determine how much money they can safely
loan you toward a home purchase or mortgage refinancing.
Everyone knows that their credit score is an important factor in
qualifying for a loan. But in reality, the DTI is every bit as
important as the credit score.

Lenders usually apply a standard called the "28/36 rule" to your
debt-to-income ratio to determine whether you're loan-worthy.
The first number, 28, is the maximum percentage of your gross
monthly income that the lender will allow for housing expenses.
The total includes payments on the mortgage loan, mortgage
insurance, fire insurance, property taxes, and homeowner's
association dues. This is usually called PITI, which stands for
principal, interest, taxes, and insurance.

The second number, 36, refers to the maximum percentage of your
gross monthly income the lender will allow for housing expenses
PLUS recurring debt. When they calculate your recurring debt,
they will include credit card payments, child support, car
loans, and other obligations that are not short-term.

Let's say your gross earnings are $4,000 per month. $4,000 times
28% equals $1,120. So that is the maximum PITI, or housing
expense, that a typical lender will allow for a conventional
mortgage loan. In other words, the 28 figure determines how much
house you can afford.

Now, $4,000 times 36% is $1,440. This figure represents the
TOTAL debt load that the lender will permit. $1,440 minus $1,120
is $320. So if your monthly obligations on recurring debt exceed
$320, the size of the mortgage you'll qualify for will decrease
proportionally. If you are paying $600 per month on recurring
debt, for example, instead of $320, your PITI must be reduced to
$840 or less. That translates to a much smaller loan and a lot
less house.

Bear in mind that your car payment has to come out of that
difference between 28% and 36%, so in our example, the car
payment must be included in the $320. It doesn't take much these
days to reach a $300/month car payment, even for a modest
vehicle, so that doesn't leave a whole lot of room for other
types of debt.

The moral of the story here is that too much debt can ruin your
chances to qualify for a home mortgage. Remember, the
debt-to-income ratio is something that lenders look at
separately from your credit history. That's because your credit
score only reflects your payment history. It's a measurement of
how responsibly you've managed your use of credit. But your
credit score does not take into account your level of income.
That's why the DTI is treated separately as a critical filter on
loan applications. So even if you have a PERFECT payment
history, but the mortgage you've applied for would cause you to
exceed the 36% limit, you'll still be turned down for the loan.

The 28/36 rule for debt-to-income ratio is a benchmark that has
worked well in the mortgage industry for years. Unfortunately,
with the recent boom in real estate prices, lenders have been
forced to get more "creative" in their lending practices.
Whenever you hear the term "creative" in connection with loans
or financing, just substitute "riskier" and you'll have the true
picture. Naturally, the extra risk is shifted to the consumer,
not the lender.

Mortgages used to be pretty simple to understand: You paid a
fixed rate of interest for 30 years, or maybe 15 years. Today,
mortgages come in a variety of flavors, such as adjustable-rate,
40-year, interest-only, option-adjustable, or piggyback
mortgages, each of which may be structured in a number of ways.

The whole idea behind all these newer types of mortgages is to
shoehorn people into qualifying for loans based on their
debt-to-income ratio. "It's all about the payment," seems to be
the prevailing view in the mortgage industry. That's fine if
your payment is fixed for 30 years. But what happens to your
adjustable rate mortgage if interest rates rise? Your monthly
payment will go up, and you might quickly exceed the safety
limit of the old 28/36 rule.

These newer mortgage products are fine as long as interest rates
don't climb too far or too fast, and also as long as real estate
prices continue to appreciate at a healthy pace. But make sure
you understand the worst-case scenario before taking on one of
these complicated loans. The 28/36 rule for debt-to-income has
been around so long simply because it works to keep people out
of risky loans.

So make sure you understand exactly how far or how fast your
loan payment can increase before accepting one of these newer
types of mortgages. If your DTI disqualifies you for a
conventional 30-year fixed rate mortgage, then you should think
twice before squeezing yourself into an adjustable rate mortgage
just to keep the payment manageable.

Instead, think in terms of increasing your initial down payment
on the property in order to lower the amount you'll need to
finance. It may take you longer to get into your dream home by
using this more conservative approach, but that's certainly
better than losing that dream home to foreclosure because
increasing monthly payments have driven your debt-to-income
ratio sky-high.

About the author:

Charles J. Phelan has been helping consumers become debt-free
without bankruptcy since 1997. A former sr. executive with one
of the nation's largest debt settlement firms, he is the author
of the Debt Elimination Success Seminar™, a five-hour audio-CD
course that teaches consumers how to choose between debt program
options based on their financial situation. The course focuses
on instruction in do-it-yourself debt negotiation. Visit
www.zipdebt.com